What is purchasing power parity?. Depreciation The loss of value of a country's currency with respect to a foreign currency If the dollar loses value.

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Presentation transcript:

What is purchasing power parity?

Depreciation The loss of value of a country's currency with respect to a foreign currency If the dollar loses value compared to another country’s currency More units of dollars are needed to buy a single unit of the other currency. The dollar is said to be “Weaker”

Appreciation The increase of value of a country's currency with respect to a foreign currency If the dollar gains value compared to another country’s currency Less units of dollars are needed to buy a single unit of the other currency. The dollar is said to be “Stronger”

Nominal Exchange Rate Important for countries because the exchange rate determines the price of imports; it determines the price of exports. Where exports and imports are large compared to GDP – movements in the exchange rate can have impacts on aggregate output and the aggregate price level ( inflation) To combat and influence this price –countries adopt exchange rate regimes.

Exchange Rate Regime A rule governing policy toward the ER Fixed Exchange Rate: When the government keeps the exchange rate against another currency at or near a particular target rate. (provides certainty but must keep large quantities of foreign currency on hand and thus low-return investment) Floating Exchange Rate: Country lets exchange rate go where ever the market takes it. (helps to insulate nation from recessions in other nations) "Managed" & "Target Zone"

The ER Regime Dilemma Advantages in Stability: takes away uncertainty of value; Commits Central Bank to Monetary policies to not upset ER (no dramatic MS increases) Disadvantages in Costs: country must keep large Q of foreign currency on hand (low-return investment)

When governments purchase or sells currency in the foreign exchange market it constitutes exchange market intervention. Foreign exchange reserves: are stock of foreign currency govts. keep to buy their own currency on the foreign market. This is done to support the price of the home currency.

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